All Too Human: 5 Behavioral Biases that Led to the Housing Crisis

Looking back, the housing debacle seems awfully predictable. In what sane world does an anonymous ranch home in Las Vegas — one of hundreds just like it, stretching to the horizon — command a half-million bucks?

It’s easy to point fingers: The Federal Reserve lowered rates, leading banks to drum up yield using under-regulated mortgage securities with lax risk standards. In their zeal to create an “ownership society,” politicians of all stripes pushed lenders to do more, more, more. The construction business, a big slice of the national economy, loved the resulting quick growth, and it filtered down to everyone. Who was going to pull the brakes on that gravy train?

In the end, though, many thousands of individuals personally signed rotten mortgage deals. What on earth where they thinking? Here’s where understanding behavioral biases can teach you a lot. You might feel you’re too smart now to fall for such an obvious bubble, but we said that after tech stocks, didn’t we?

Better to learn from the fresh example right in front of us: housing. Here are the biases that fed the boom and are likely to play a role in the next one, whatever the asset class.

1) “Birds do it, bees do it…”Herd behavior isn’t hard to spot. If you’ve ever been in a packed nightclub or at a huge outdoor concert, you know the dizzying impression that the crowd dynamic might spin out of control. Yet the illusion, in investing terms, is quite contrary: We feel oddly safer when others are falling for the same scam. How on earth could housing possibly decline? Everyone is making a ton of money!

That weird feeling of safety in numbers, the “herd behavior” bias, is really much more like the overcrowded club. Queasy? Find an exit, fast. You’ll feel better on the street outside, looking in.

2) “Little pink houses for you and me…” Home ownership is the American dream. And what could be safer and more reliable than putting money into your own abode? Turns out, lots of things. We understand our homes much better than we do Treasury bonds or the stock market. You can get a bucket of paint and improve your home. Equities are totally in the hands of distant strangers.

“Familiarity” with an investment is a bias. You start to believe that you understand something so well that the risk is minimized or falls to zero. Don’t get comfortable, even if you think you are in control. Too often, you simply are not.

3) “Your love keeps lifting me, higher and higher…” Look online at home prices. What you see is the seller’s offer. What you don’t (but can eventually figure out through public records) is the final sale number, which is clearly going to be lower.

Except when it isn’t, which is what happens in a bubble, whether it’s housing, stocks, commodities, or tulip bulbs. There’s a couple of biases at work here. First, we believe that the things we own are more valuable by virtue of our ownership of them. This is the “endowment effect.”

In the housing boom, the endowment effect joined in unholy matrimony with the “disposition effect,” the bias toward keeping a winning hand in play, even beyond reason. We thought our houses were uniquely valuable. (Granite counter tops! Stainless steel appliances!) Then rising prices, fueled by inordinately cheap financing, reinforced the illusion. Oops.

4) “I have become comfortably numb…” We loved the idea that our homes were going to save the day. Retirement, solved! Rainy day fund, solved! Easy cash flow via home equity, solved! Rising housing prices seemed to offer a stable future for everyone. It even felt, as illogical as it sounds now, as if people who failed to buy a home might be left behind.

As the saying goes, never stand in line to buy an asset. The bias we fight on this front is “cognitive dissonance,” wherein we congratulate ourselves too quickly on a winning strategy and too easily erase the risks. We see what we want to see. Any contrary information is simply wrong, according to our new, collective worldview.

5) “Never gonna give you up, never gonna let you down…” Why on earth didn’t people sell earlier, when real estate was peaking? Ah, the ultimate mystery. The most common refrain was, “Well, where am I going to live?” But the truth is simpler: We hate choosing. This is “attachment bias.” It’s much easier to sit on our hands and wait for something to happen.

Of course, something did happen. Housing crashed, wiping out trillions of illusory wealth and taking down the global economy for good measure. Every small, slightly bad choice added up to quite an impact, once our all-too-human biases were in play.